Academic journal article Journal of Real Estate Literature

Review Article: Evidence on Rationality in Commercial Property Markets: An Interpretation and Critique

Academic journal article Journal of Real Estate Literature

Review Article: Evidence on Rationality in Commercial Property Markets: An Interpretation and Critique

Article excerpt


Periodic sharp sustained increases and then reversals in asset prices lead many to posit irrational price bubbles. The general case for irrationality is that real asset prices simply have moved too much given the future real cash flows the assets are reasonably likely to produce. A specific argument for property is that observed mean reversion in real cash flows has not been reflected in investor valuations, resulting in asset values being too high when real cash flows were high and vice versa. This study interprets, critiques and extends existing analyses of movements in real commercial property prices during the late 1980s and early 1990s.

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Sharp price reversals in asset values during the early 1990s have raised questions regarding the rationality of markets. For property, real office values in the OECD countries fell by an average of 55% between the late 1980s/early 1990s peak and the trough after nearly doubling between 1985 and the peak (Hendershott, Hendershott and Ward, 2003). The boom in technology and Internet stocks in the late 1990s and subsequent reversal raised even greater concerns regarding the rationality of the stock markets in the United States (Shiller, 2000). That is, many argue that asset bubbles-sharp, temporary price increases that cannot be plausibly explained by changes in fundamental value drivers-have occurred.

A number of alternatives to blind irrationality can explain price spikes. First, expected rates of growth in real cash flows and real discount rates may move abruptly, causing sharp changes in fundamental values.1 Moreover, for property, high transactions costs and long construction periods could prevent rapid supply responses to gaps between fundamental value and replacement cost, rationalizing high market values (transactions costs are generally far higher and production periods far longer for direct property than for stocks).

Second, principal-agent problems could cause agents rationally to bid prices significantly above fundamental value. In the property development market, developers can expect the profits of high development values but, as they are likely to have borrowed against the completed development value, have more limited downside risk. More generally, large scale investments, whether in the property or the stock market, are typically undertaken by financial institutions where those making the investment decisions are not those whose money is being invested. Because the agents making the investments are rewarded on short-term relative performance and feel they are unable to predict the timing (rather than incidence) of a price reversal (Barberis, Shleifer and Vishney, 1998), agents may continue buying (or at least may not sell) even when they believe that market prices are above their 'fundamental' values. If agents sell too soon and the market keeps rising, they will incur negative relative performance, but if they are still in the market along with competitors when it collapses, there will be no negative differential performance. On the other hand, keeping an eye on competitors means that once the market begins to turn, everyone wants out and collapse becomes self-fulfilling (Ball, Lizieri and MacGregor, 1998).

Third, minor degrees of irrationality, what is often called "bounded rationality," may exist. While economic theory provides limited guidance about what particular elements of irrationality exist among investors, a number of papers show that limited deviations from full rationality can lead prices to deviate from fundamental values in predictable ways. Barberis, Shleifer and Vishny (1998) focus on investor conservatism-the reluctance to update beliefs in the face of new information-and Daniel, Hirshleifer and Subrahmanyam (1998) emphasize overconfidence-the tendency to overestimate the quality of one's own information-as particular cognitive biases that can affect asset prices. …

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